11th Edition

Chapter 8

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 Activity-Based Costing: A
Tool to Aid Decision Making

Chapter Eight

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 Activity Based Costing (ABC)

ABC is a
ABC is designed to good supplement
provide managers with to our traditional
cost information for cost system
I agree!
strategic and other
decisions that potentially
affect capacity and
therefore affect fixed as
well as variable costs.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Manufacturing Nonmanufacturing
costs costs

Traditional ABC
product costing product costing

 ABC assigns both types of costs to products.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Manufacturing Nonmanufacturing
costs costs

Some
Mo
st,
not but
All

all

Traditional ABC
product costing product costing

 ABC does not assign all manufacturing costs to products.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
Level of complexity

Activity–Based
Activity–Based
Costing
Costing

Departmental
Departmental
Overhead
Overhead
Rates
Rates
Plantwide
Plantwide
Overhead
Overhead
Rate
Rate

Number of cost pools

 ABC uses more cost pools.
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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Volume
Allocation Bases

measures
Bases usually plus other
Number of

rely solely on bases.

volume
measures.

Traditional Costing ABC

 ABC uses more allocation bases.
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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

The
The most
most commonly
commonly usedused allocation
allocation base
base
in
in traditional
traditional costing
costing is
is direct
direct labor
labor hours.
hours.

Direct labor hours

work
well when overhead
increases as direct
labor hours increase.

 ABC uses more allocation bases.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

The
The most
most commonly
commonly usedused allocation
allocation base
base
in
in traditional
traditional costing
costing is
is direct
direct labor
labor hours.
hours.

Problems:
 In many processes, overhead is increasing
while direct labor is decreasing.
 Variety and complexity of products is
increasing.

 ABC uses more allocation bases.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

ABC uses
volume as well as
other allocation bases not
All overhead related to the volume
costs are not related of production.
to volume measures like
direct labor
hours.

 ABC uses more allocation bases.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Traditional Costing ABC

The predetermined
overhead rate is based
on budgeted activity.
This results in applying
all overhead costs
including unused, or
idle capacity costs to
products.
Products are charged
for the costs of
capacity they use – not
for the costs of
capacity they don’t
use. Unused capacity
costs are treated as
period expenses.

 ABC bases level of activity on capacity.

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 Characteristics of Successful
ABC Implementations

Strong
Strong top
top
management
management support
support
Link
Link to
to evaluations
evaluations
and
and rewards
rewards

Cross-functional
Cross-functional
involvement
involvement

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 Designing an ABC System

Cost Objects
(e.g., products Activities
and customers)

Consumption
of Resources

Cost

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 Designing an ABC System

Steps for Implementing ABC

 Identify and define activities and activity cost
pools.
 Trace costs to activities and cost objects.
 Assign costs to activity cost pools.
 Calculate activity rates.
 Assign costs to cost objects.
 Prepare management reports.

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  Identify and Define Activities
and Activity Cost Pools

Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
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  Identify and Define Activities
and Activity Cost Pools

Activities
should only be
combined within a level
if they are highly
correlated.

When combining
activities, they should be
grouped together only at
the appropriate
level.

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  Identify and Define Activities
and Activity Cost Pools

An Activity Cost $$
Pool is a “bucket” in $
$ $
which costs are $
accumulated that
relate to a single
activity measure in
the ABC system.

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  Identify and Define Activities
and Activity Cost Pools

Two types of activity

measures:

Transaction Duration
driver driver

Simple count A measure

of the number of of the amount
times an activity of time needed
occurs. for an activity.

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  Identify and Define Activities
and Activity Cost Pools

At Classic Brass, the ABC team, selected the following

activity cost pools and activity measures:
Activity Cost Pools at Classic Brass
Activity Cost Pool Activity Measure
Customer orders Number of customer orders
Product design Number of product designs
Order size Machine-hours
Customer relations Number of active customers
Other Not applicable

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  Identify and Define Activities
and Activity Cost Pools

•• Customer
Customer Orders
Orders -- assigned
assigned allall costs
costs ofof resources
resources
that
that are
are consumed
consumed by by taking
taking and
and processing
processing
customer
customer orders.
orders.
•• Product
Product Designs
Designs -- assigned
assigned allall costs
costs ofof resources
resources
consumed
consumed by by designing
designing products.
products.
•• Order
Order Size
Size -- assigned
assigned all
all costs
costs of
of resources
resources
consumed
consumed as as aa consequence
consequence of of the
the number
number of of units
units
produced.
produced.
•• Customer
Customer Relations
Relations –– assigned
assigned allall costs
costs associated
associated
with
with maintaining
maintaining relations
relations with
with customers.
customers.
•• Other
Other –– assigned
assigned all
all overhead
overhead costs
costs that
that are
are not
not
associated
associated with
with the
the other
other cost
cost pools.
pools.
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  When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Indirect factory wages $ 500,000
Factory equipment depreciation 300,000
Factory utilities 120,000
Factory building lease 80,000 $ 1,000,000
Shipping costs traced to customer orders 40,000
General Administrative Department
Administrative wages and salaries 400,000
Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Marketing Department
Marketing wages and salaries 250,000
Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000

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  Assign Costs to Activity Cost Pools

At Classic Brass the following distribution of resource

consumption across activity cost pools is determined.
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory w ages 25% 40% 20% 10% 5% 100%
Factory equipment depreciation 20% 0% 60% 0% 20% 100%
Factory utilities 0% 10% 50% 0% 40% 100%
Factory building lease 0% 0% 0% 0% 100% 100%
Shipping costs **
General Administrative Department
Administrative w ages and salaries 15% 5% 10% 30% 40% 100%
Office equipment depreciation 30% 0% 0% 25% 45% 100%
Administrative building lease 0% 0% 0% 0% 100% 100%
Marketing Department
Marketing w ages and salaries 20% 10% 0% 60% 10% 100%
Selling expenses 10% 0% 0% 70% 20% 100%

**Not included because they are directly traced to customer orders.

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  Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Indirect factory wages $ 500,000
Activity Cost Pools Factory equipment depreciation 300,000
Customer Product Factory utilities
Order Customer 120,000
Factory building lease 80,000 $ 1,000,000
Orders Design Size Relations Other Total
Shipping costs traced to customer orders 40,000
Production Department General Administrative Department
Indirect factory wages $ 125,000 Administrative wages and salaries 400,000
Factory equipment depreciation Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Factory utilities Marketing Department
Factory building lease Marketing wages and salaries 250,000
General Administrative Department Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Indirect
Indirect factory
factory wages
wages $500,000
$500,000
Percent
Percent consumed
consumed byby customer
customer orders
orders 25%
25%
$125,000
$125,000

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  Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Indirect factory wages $ 500,000
Activity Cost Pools Factory equipment depreciation 300,000
Customer Product Factory utilities
Order Customer 120,000
Factory building lease 80,000 $ 1,000,000
Orders Design Size Relations Other Total
Shipping costs traced to customer orders 40,000
Production Department General Administrative Department
Indirect factory wages $ 125,000 Administrative wages and salaries 400,000
Factory equipment depreciation 60,000 Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Factory utilities Marketing Department
Factory building lease Marketing wages and salaries 250,000
General Administrative Department Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Factory
Factory equipment
equipment depreciation
depreciation $300,000
$300,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
20%
$$ 60,000
60,000

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  Assign Costs to Activity Cost Pools

Activity Cost Pools

Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000
Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000
Factory utilities - 12,000 60,000 - 48,000 120,000
Factory building lease - - - - 80,000 80,000
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000
Office equipment depreciation 15,000 - - 12,500 22,500 50,000
Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000

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  Calculate Activity Rates

The ABC team determines that Classic Brass will

have these total activities for each activity cost
pool . . .
 1,000 customer orders,
 200 new designs,
 20,000 machine-hours,
 100 customer relations activities.

Now
Now the
the team
team can
can compute
compute the the individual
individual
activity
activity rates
rates by
by dividing
dividing the
the total
total cost
cost for
for
each
each activity
activity by
by the
the total
total activity
activity levels.
levels.
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  Calculate Activity Rates

Computation of Ac tivity Rates

(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders $ 315,000 1,000 orders $315 per order
Product design 257,000 200 designs $1,285 per design
Order size 380,000 20,000 MHs $19 per MH
Customer relations 367,500 100 customer $3,675 per customer
Other 490,500 Not applicable Not applicable

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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Cost Objects:
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Second-Stage Allocations

$/MH $/Order $/Design $/Customer

Cost Objects:
Unallocated
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
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  Assigning Costs to Cost Objects

Let’s take a look at how our system works

for just one customer – Windward Yachts.
Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours.
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
6. Shipping costs total $180.
Custom Compass Housing (requires new design)
1. One order during the year.
2. Each housing required 4 machine-hours.
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labor totals $50.
6. Shipping costs total $25.
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  Assigning Costs to Cost Objects

Overhead Cost for the Standard Stanchions

(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 315 2 $ 630
Product design 1,285 0 -
Order size 19 200 3,800
Customer relations 3,675 N/A

The customer-level Overhead Cost for the Custom Housing

(a) (b) (a) × (b)
cost is assigned to Activity Cost Pools
Customer orders
Activity Rate
$ 315
Activity
1
ABC Cost
$ 315
customers directly; Product design
Order size
1,285
19
1
4
1,285
76
it is not assigned to Customer relations 3,675 N/A

products.

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  Prepare Management Reports

Standard Stanchions
Sales $ 13,600
Cost:
Direct materials $ 2,110
Direct labor 1,850
Shipping costs 180
Customer orders 630
Product design -
Order size 3,800 8,570
Product margin $ 5,030
Custom Compass Housing
Sales $
Cost:
Direct materials $ 13
Direct labor 50
Shipping costs 25
Customer orders 315
Product design 1,285
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76 Inc.
  Prepare Management Reports

Customer Profitability Analysis

Windward Yachts
Product margins:
Standard stanchion $ 5,030
Custom compass housing (1,114
Total product margin 3,916
Less: Customer relations 3,675
Customer margin $ 241
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 Product Margins

Traditional Cost Accounting System

Standard Compass
Stanchions Housing
Sales $ 13,600 $ 650
Costs
Direct materials (2,110) (13)
Direct labor (1,850) (50)
Manufacturing overhead (10,000) (200)
Product margin $ (360) $ 387

400
400 units
units xx 0.5
0.5 MH/unit
MH/unit xx $50/MH
$50/MH == $10,000
$10,000

Predetermined manufacturing $1,000,000

= = $50/MH
overhead rate 20,000 MH
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 Differences Between ABC and
Traditional Product Costs
Product margins are different for four reasons:
 Traditional costing assigns design costs to both products
based on machine hours. ABC assigns product design
costs to a product only if product design work is required.
 Traditional costing assigns customer order costs, a batch-
level cost, using a unit-level allocation base, machine hours.
ABC assigns these batch-level costs using a batch-level
activity measure.
 Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to
products.
 Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organization-
sustaining manufacturing costs to the products.
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 Differences Between ABC and
Traditional Product Costs

When batch-level and

product-level costs are present,
ABC will usually shift costs from high
volume products, produced in large batches,
to low volume products produced in small batches.

This cost shifting will usually have its

greatest impact on the per
unit cost of the low
volume products.

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 Targeting Process Improvement

Activity-based management is
used in conjunction with ABC to
identify areas that would benefit
from process improvements.

While the theory of constraints

approach discussed in Chapter 1 is a
powerful tool for targeting
improvement efforts, activity rates
can also provide valuable clues on
where to focus improvement efforts.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Activity-Based Costing and External Reporting

Most companies do not use ABC

for external reporting because . . .
1.
1. External
External reports
reports are
are less
less detailed
detailed than
than internal
internal
reports.
reports.
2.
2. ItIt may
may be
be difficult
difficult to
to make
make changes
changes to
to the
the company’s
company’s
accounting
accounting system.
system.
3.
3. ABC
ABC does
does not
not conform
conform to
to GAAP.
GAAP.
4.
4. Auditors
Auditors may
may be
be suspect
suspect ofof the
the subjective
subjective allocation
allocation
process
process based
based on
on interviews
interviews with
with employees.
employees.

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 ABC Limitations

Substantial resources Resistance to

required to implement unfamiliar numbers
and maintain. and reports.

Desire to fully Potential

allocate all costs misinterpretation of
to products. unfamiliar numbers.

Does not conform to

GAAP. Two costing
systems may be needed.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Appendix 8A: ABC Action Analysis

Conventional
Conventional ABC ABC analysis
analysis does does not
not
identify
identify potentially
potentially relevant
relevant costs.
costs. AnAn
action
action analysis
analysis report
report helps
helps because
because it: it:
•• Shows
Shows what
what costs
costs have
have beenbeen
assigned
assigned to to aa cost
cost object.
object.
•• Indicates
Indicates how
how difficult
difficult itit would
would bebe to
to
adjust
adjust those
those costs
costs inin response
response to to
changes
changes in in the
the level
level of
of activity.
activity.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Appendix 8A: ABC Action Analysis

Constructing an action analysis report

begins with the first-stage allocation
process. In addition to computing an
overall activity rate for each activity cost
pool, an activity rate is computed for each
type of overhead cost that is consumed
supporting a given activity.
Let’s revisit the stage-one allocations
from the Classic Brass example that we
discussed earlier.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Appendix 8A: ABC Action Analysis Activity Cost Pools

Custom e r Product Orde r Custom e r

Orde rs De sign Size Re la tions Othe r
Tota l Activity 1,000 200 20,000 100 N/A
P roduction De pa rtm e nt
Indire ct fa ctory w a ge s $ 125 $ 1,000 $ 5 $ 500
Fa ctory e quipm e nt de pre cia tion 60 - 9 -
Fa ctory utilitie s - 60 3 -
Activity Cost Pools
Fa ctory building le a se - - - -
Customer Product Ge neOrder
ra l Adm inistra Customer
tive De pa rtm e nt
Orders Design AdmSizeinistra tive Relations
w a ge s a nd sa la rieOther
s 60 100Total2 1,200
Office e quipm e nt de pre cia tion 15 - - 125
Production Department Adm inistra tive building le a se - - - -
Indirect factory wages $ 125,000 $ 200,000 M a$rke100,000
ting De pa rtm$ e nt50,000 $ 25,000 $ 500,000
Factory equipment depreciation 60,000 - Ma180,000
rke ting w a ge s a nd sa - la rie s 60,000 50 125 300,000
- 1,500
Se lling e x pe nse s 5 -
Factory utilities - 12,000 60,000 - 48,000 120,000 350
-
Tota l $ 315 $ 1,285 $ 19 $ 3,675
Factory building lease - - - - 80,000 80,000
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000
Office equipment depreciation 15,000 - - 12,500 22,500 50,000
Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000

$125,000 ÷ 1,000 orders = $125 per order

Other entries in the table are computed similarly.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Appendix 8A: ABC Action Analysis
Action Analysis Cost Matrix for Standard Stanchions
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Total
Total activity for stanchions 2 - 200 N/A
Production Department
Indirect factory wages $ 250 $ - $ 1,000 $ 1,250
Factory equipment depreciation 120 - 1,800 1,920
Factory utilities - - 600 600
Factory building lease - - - -
General Administrative Department - -
Administrative wages and salaries 120 - 400 520
Office equipment depreciation 30 - - 30
Administrative building lease - - - -
Marketing Department - -
Marketing wages and salaries 100 - - 100
Selling expenses 10 - - 10
Total $ 630 $ - $ 3,800 $ 4,430

$125 per order × 2 orders = $250

Other entries in the table are computed similarly.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Appendix 8A: ABC Action Analysis
Action Analysis Cost Matrix for Custom Compass Housing
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Total
Total activity for compass housing 1 1 4 N/A
Production Department
Indirect factory wages $ 125 $ 1,000 $ 20 $ 1,145
Factory equipment depreciation 60 - 36 96
Factory utilities - 60 12 72
Factory building lease - - - -
General Administrative Department - -
Administrative wages and salaries 60 100 8 168
Office equipment depreciation 15 - - 15
Administrative building lease - - - -
Marketing Department - -
Marketing wages and salaries 50 125 - 175
Selling expenses 5 - - 5
Total $ 315 $ 1,285 $ 76 $ 1,676

$125 per order × 1 orders = $125

Other entries in the table are computed similarly.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Appendix 8A: ABC Action Analysis

Next,
Next, label
label each
each cost
cost using
using an
an ease
ease ofof adjustment
adjustment
code:
code:
•• Green
Green costs
costs adjust
adjust more
more or
or less
less automatically
automatically to to
changes
changes in in activity
activity level
level without
without any
any action
action by
by
managers.
managers.
•• Yellow
Yellow costs
costs cancan be
be adjusted
adjusted toto changes
changes in in activity
activity
level,
level, but
but itit would
would require
require management
management action action to
to
realize
realize the
the change
change in in cost.
cost.
•• Red
Red costs
costs cancan bebe adjusted
adjusted to to changes
changes in in activity
activity
level
level only
only with
with aa great
great deal
deal difficulty
difficulty and
and with
with
management
management intervention.
intervention.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Appendix 8A: ABC Action Analysis

Action Analysis of Custom Compass Housing

Sales $ 650
Green costs
Direct materials $ 13
Shipping costs 25 38
Green margin $ 612
Yellow costs
Direct labor 50
Indirect factory wages 1,145
Factory utilities 72
Administrative wages and salaries 168
Office equipment depreciation 15
Marketing wages and salaries 175
Selling expenses 5 1,630
Yellow margin $ (1,018)
Red costs
Factory equipment depreciation 96
Factory building lease -
Administrative building lease - 96
Red margin $ (1,114)

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 End of Chapter 8

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.